Based on self-executing code, smart contracts are electronic contracts that automatically implement the terms of an agreement between parties. The technology is often mentioned alongside other developments such as blockchain, virtual currencies and machine learning, although smart contracts can operate independently of these technologies.
Smart contracts can reduce transaction cost by automating certain administrative or legal processes, potentially reducing reliance on the services of an intermediary or lawyer. A smart contract can automatically issue documentation, make a payment, conclude a trade or exchange an asset according to the instructions set out in the code.
The technology has been around since the 1990s, but has gained popularity with the development of blockchain, particularly with virtual currency platforms like Ethereum. However, smart contracts (and blockchain) are now finding uses in a wide range of sectors including; supply chains, trade, logistics, energy contracts, government and financial services, including insurance.
For example, the use of smart contracts in the motor insurance market could result in USD 21 billion annual cost savings globally, according to CapGemini Consulting. For investment banking, smart contracts could halve the average time taken to settle loans, while the mortgage market could result in savings of USD 3 -11 billion.
Why does it matter?
The global smart contracts market is expected to be worth USD 300 million by 2023, with a compound annual growth rate of 32%. Smart contracts are being tested alongside blockchain initiatives in a number of sectors including; insurance, banking and shipping. The technology is expected to become more common in the next five years, with mainstream adoption within a decade.
Despite the benefits, smart contracts face a number of challenges. Regulation has yet to keep pace with the technology, while tax and legal questions remain – the UK’s Law Commission is to review the current English legal framework as it applies to smart contracts. The Law Commission raises questions about how the technology would interact with contract law concepts, as well as questions about interpretation, liability, applicable law and dispute resolution.
Cyber security is another key consideration. Some 25% of all smart contracts may contain bugs, while 60% have at least one security issue, according to cyber security firm Hosho, which audits smart contracts. Last year, smart contract coding company Parity warned of a vulnerability in its smart contract software that resulted in the theft of USD 30 million of cryptocurrency.
Adult entertainment website SpankChain said earlier this year that its smart contract facility had been hacked and funds were stolen. The criminals exploited the so-called “re-entrancy” bug in smart contracts – the same flaw was used to steal USD 50 million in cryptocurrency from crowd funding project DAO.
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